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SAJEMS NS 9 (2006) No 1
89
FINANCIAL LIBERALISATION AND INFLATIONARY DYNAMICS IN THE
CONTEXT OF A SMALL OPEN ECONOMY
Rangan Gupta
Senior Lecturer, Department of Economics, University of Pretoria 1
Abstract
This paper develops a short-term model of a small open financially repressed economy
characterised by unorganised money markets, intermediate goods imports, capital mobility and
flexible exchange rates. The analysis shows that financial liberalisation, in the form of increased
rate of interest on deposits and tight monetary policy, causes deflation for an economy with a high
degree of capital mobility. However, for economies with a low degree of capital mobility, the
possibility of stagflation cannot be ruled out. These results suggest that financial liberalisation in the
form of lower reserve requirements should be recommended for economies with restricted
transactions in the capital account.
JEL E31, E44, E52, F41
1
Introduction
Using a modified Mundell-Fleming model that
accounts for financial repression, this paper
analyses the effects of financial liberalisation
on inflation. Financial restriction consists of
three elements: first, the banking system is
favoured and protected because the government
can finance the budget deficit at a low or zero
cost by forcing the banks to hold government
bonds and money through the imposition of
“high” multiple reserve requirements; second,
since government revenue cannot be extracted
very easily from private securities, the
development of private bond and equity markets
are discouraged, and; finally, interest rate
ceilings are imposed on the banking system to
encourage low-cost investment and curtail
competition with public sector fund-raising
from the private sector. In this context, financial
liberalisation is defined as relaxation of the
interest-rate ceiling and lowering of reserve
requirements.
Since the break-up of the old colonial
empires, many developing economies have
suffered from stagnant economic growth,
persistent inflation and external imbalances
under financial repression. To cope with these
difficulties, McKinnon (1973) and Shaw (1973)
advocate a high interest-rate policy to accelerate
growth with lower inflation. Such policy
prescriptions have come to be associated with
the Liberal school, which in its analysis tends
to assume that financial sector development is
the precursor to economic growth. Influential
analysis of financial liberalisation initiated by
the Liberal school has been strongly criticised
by a group of economists adhering to the New
Structuralist school. These economists,
including Van Wijnbergen (1982, 1983 &
1985), Buffie (1984), Kohsaka (1984) and Lim
(1987) postulate that the financial markets of
many developing countries are characterized
by competitive and agile Unofficial Money
Markets (UMMs), which absorb the excess
demand for credit from the official banking
system; this is an implication of the interest rate
ceilings. The New Structuralists indicate that
in such an environment an increase in the
nominal interest rate on deposits will cause
households to reallocate their portfolios towards
bank deposits at the expense of UMM securities,
which in turn will cause the total supply of credit
to the business sector to decline as funds are
90
shifted out of the UMM into the banking system.
The reallocation occurs because the banking
system, in the presence of reserve requirements,
provides partial intermediation whereas the
UMM, with no reserve requirements, provides
one-to-one intermediation. As a result, this
reallocation reduces the total supply of credit,
causing the UMM rate to go up to clear the
credit market. The associated increase in the
cost of funds to finance working capital shifts
the aggregate supply to the left, and output falls
while inflation rises. (See Karapatakis, 1992,
for a comprehensive literature review on
financial repression.)
The objective of this analysis is to show that
the stagflationary outcome predicted by the
New Structuralist school is not a certain result,
when flexible exchange rates, import of
intermediate inputs and capital mobility are
allowed for. This argument is closely related to
the recent theoretical work of Nag and
Mukhopadhyay (1998), who show that the new
structuralist claim of a tight monetary policy
and interest rate deregulation, propagated by
Van Wijnbergen (1982, 1983, 1985 and 1986),
is radically altered when import penetration and
a flexible exchange rate are considered.
The argument of this present study builds on
the work of Nag and Mukhopadhyay (1998),
firstly by incorporating capital account mobility,
which they do not include in their study.
Secondly, while they assume that the economy
is characterised by perfect wage indexation,
which is typically not the case in a small open
financially repressed country, this paper
develops a flexible model that allows varied
levels of wage indexation to be considered,
including both extremes of no and perfect wage
indexation. Thirdly, Nag and Mukhopadhyay
use a phase-diagram analysis to obtain their
results, while this study draws its results from a
more tractable IS-LM-BP(AD)-AS model,
which allows solutions focused explicitly on the
endogenous variables of a model. Using an ISLM-BP(AD)-AS model also allows the
endogenising of money supply, and, hence, the
incorporation of the role of reserve
requirements. Analysis of reserve requirements
is important, since even though most economies
around the world have deregulated interest
SAJEMS NS 9 (2006) No 1
rates, the financial sector continues to be
repressed through high mandatory reserve
requirements (see Gupta, 2005, for a detailed
review). This study can thus be viewed as a
complementary and extended version of that of
Nag and Mukhopadhyay (1998), better adapted
to reality.
With these modifications to the model, and
allowing for the role of intermediate inputs in
the production process, higher interest rates on
deposits and tighter monetary policy can be
shown to be likely to cause deflation in an
economy with high capital mobility. Moreover,
financial liberalisation in the form of lower
reserve requirements can increase output and
lower inflation, if the country is subjected to
restricted capital account transactions.
This argument will now be set out in two
sections: Section 2 sets out the economic
environment and Section 3 solves the model
and discusses the effects of financial
liberalisation on the rate of inflation.
2
The model
For the sake of argument, let us consider a small
open economy, operating under a floating
exchange rate regime, with one type of
domestically produced goods and two different
types of imported goods (one consumption and
one imported intermediate), used in the
production of domestic output. The price of
the domestic goods is endogenous, whilst the
prices of the imported goods, both consumption
and capital, are exogenous. The supply function
of the importables is perfectly elastic at a foreign
currency price of P*. Since P* is parametrically
given to the economy, let us assume it is set at
unity for the sake of simplicity. Notice that an
implicit assumption is that the production
transformation schedule is linear for the
imported consumption goods and the
intermediate goods, so that the same technology
applies to both kinds of importables and they
sell for the same price of P*.
Repression is assumed to be severe enough
to give rise to UMMs, popularly called the
“curb” markets. A curb market is an informal
SAJEMS NS 9 (2006) No 1
credit market in which money lenders and
indigenous banks are intermediate between
savers and borrowers and are outside the realm
of the regulations of the monetary authority.
Because of the absence of reserve requirements,
the curb market is often viewed as a competitive
and agile credit market providing more
efficient intermediation than the official
banking system. Moreover, since the banking
system operates under interest rate regulations
and high reserve requirements, the curb market
can be viewed as a residual market that absorbs
the excess demand for credit from the official
banking system.
Firms unable to obtain low cost funds from
the banking system at the regulated lending rate
turn to the UMM to satisfy their borrowing
needs to finance intermediate input and
physical capital requirements. The freely
determined rate in the curb market is much
higher than the deposit and loan rates in the
official banking system, and reflects true
marginal cost of production. Hence, the UMM
rate of interest appears as an argument in both
the aggregate demand and aggregate supply side
of the model.2
Our model of a small open financially
repressed economy is a modified version of the
standard Mundell-Fleming model as outlined
in Argy (1994). The basic structure of the
economy can be laid out by considering four
interrelated markets, namely, the labour,
commodity, money and foreign exchange
markets. We begin with the labour market.
Unlike the standard Mundell-Fleming model,
the aggregate supply curve in our economy is
not perfectly elastic but is upward sloping under
reasonable assumptions about wage-price
flexibility. Since this is a short-run model, the
aggregate supply, QS, is determined by the
conditions prevailing in the labour market and
the imported intermediate goods requirement,
as shown in equation 1:
1n QS = b1[(InW – InPd)] – b2[Ine – InPd) + rc] (1)
where W = nominal wage, Pd = domestic price
level, e = nominal exchange level and rc = real
interest rate of the curb market, respectively,
and b i > 0, i =1. 2,
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Equation (1) states that the quantity supplied is
negatively related to the marginal cost of hiring
one additional unit of labour and the
intermediate imported input. Note that the wage
cost is assumed to be financed through retained
earnings of the firms, while the intermediate
input is purchased through loans from both the
banks and the UMM. This is merely a
simplification and, assuming that labour costs
are also loan-financed, does not change the final
results while simplifying the equation’s
coefficients. It is also assumed that firms do not
want to tie up their retained earnings in dealings
with foreign suppliers; many foreign suppliers
require advance payment, hence the firms’
reliance on loans. Thus, the interest rate of the
curb market, which reflects the true marginal
cost of production, enters as an argument into
the aggregate supply curve, besides the real
exchange rate.
Nominal wage is assumed to be indexed to
the consumer price index (P), i.e., W = b3P,
where b3 reflects the degree of wage indexation,
and the consumer price index (CPI) is the
weighted average of the price of home good (Pd)
and the price of imported good (eP*). Since P*
is unity, movements in the price of imported
goods are completely determined by variations
in the nominal exchange rate, e. So the CPI is
given by equation 2:
1n P = b41n Pd + (1 – b4) 1n e
(2)
Note, b3 lies in the closed interval of 0 to 1. We
will derive a general expression for the aggregate
supply curve and mainly consider the case of
no-wage indexation (b3=0), which corresponds
to a more realistic situation in the labour
markets of the developing world. However, as a
corollary we will observe what happens when
there is perfect wage indexation (b 3=1).
Assuming b3=0 implies that the nominal wage
is fixed and normalised to 1. We can then treat
the nominal wage as parametric in the model,
implying that employment is demanddetermined. This is not an irrelevant assumption, especially in the short term when in the
face of continuous unemployment, labour
supply is rendered perfectly elastic. Moreover,
though they state wages and working contracts
in great detail, most union contracts ensure that
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SAJEMS NS 9 (2006) No 1
the right to adjust employment in response to
changes in economic conditions is mostly
reserved for the hiring firm (Addison & Siebert,
1979).
Substituting (2) into (1) and introducing
time, the aggregate supply equation becomes
equation 3:
1n 4WV = [b2 + b1b3 (1 – b3b4)1n Pdt –
[b2 +b1b3 (1 – b4)1net – b2rct
(3)
Next, we turn our attention to the commodity
market. The aggregate demand is positively
related to the level of government expenditure
G, exogenous foreign output Yf and the real
exchange rate (lne-lnPd). The real interest rate
in the curb market rc negatively influences the
domestic investment demand and hence the
aggregate demand. We postulate an IS curve
given by equation 4:
1n 4WG = a1(1net – 1nPdt) + a2 1nGt – a3rct
+ a4 1nYft
(4)
where ai > 0, i= 1, 2, 3, 4.
Before we look into the money market, it is
worthwhile discussing the structure of the
banking sector. The central bank sits at the apex
of all monetary activities, and maintains stability
by controlling the base money and credit
availability in the economy. For this purpose,
the central bank imposes reserve ratio
requirements on commercial bank deposits and
interest rate regulations on loans and deposits.
The UMM, operating outside the realm of the
central bank, is subjected to neither interest rate
control nor reserve requirements. The freely
determined interest rate of the curb market
helps in clearing the money market.
To incorporate the role of reserve
requirements, we must endogenise the supply
of money. The money demand equation is
designed to follow the New Structuralist
paradigm, and so the nominal demand for
money is given in equation 5:
In 0 WG = 1nPdt + d1 1nYt + d2 L
dt
– d3ict
(5)
where 0 WG = nominal money demand, Yt =
real gross domestic product, L d = nominal
interest rate on deposits and ict = nominal
interest rate on the curb market loans. Note,d1
> 0, i = 1, 2, 3. Note that, following the New
Structuralist argument, we assume that a rise in
the bank deposit rate (UMM rate of interest)
causes a reallocation in households’ portfolios
toward bank deposits (UMM securities) at the
expense of UMM securities (bank deposits) and
not cash, thus causing money demand to
increase (decrease). This is not an irrational
assumption for a developing world, where most
goods are cash goods, so that the demand for
currency is pretty inelastic in relation to changes
in the opportunity cost variables. See Van
Wijnbergen (1982, 1983 and 1985), Buffie
(1984), Kohsaka (1984), Lim (1987), Nag and
Mukhopadhyay (1998), and Nag (2000) for
theoretical validation of this formulation of
money demand in a financially repressed
economy, and Van Wijnbergen (1982 and 1985)
and Lim (1987) for empirical support of the
same.
The money supply function can be
formulated as follows. Money supply is the sum
of currency in circulation (C), and supply of
bank deposits (D), whereas base or highpowered money (H) is the sum of currency and
reserves (R). Thus
(Ms )/H= ((C/D)+1)/(C/D+RR/D+ER/D) (6)
where RR = required reserve, ER = excess
reserves, and Ms is the nominal supply of money.
Alternatively,
Ms=((1+cu)/(cu+q+ex))H
(7)
where cu = currency deposit ratio, q = required
reserve ratio and ex = excess reserves to deposit
ratio.
Simple intuition suggests that the currency
deposit ratio and the excess reserve to deposit
can be postulated as a negative function of Y,
and L dt and a positive function of i c. The
rationale for the sign of the currency-deposit
ratio with respect to the interest rates is obvious,
given that the currency demand is pretty inelastic
with respect to interest rate movements.
However, as Y increases, both C and D rise, but
since with the growth of banking habits more
payments are settled through banks, deposits
increase at a faster rate than currency. Hence,
the currency-deposit ratio can be postulated to
be a negatively correlated with the level of
SAJEMS NS 9 (2006) No 1
93
income. On the other hand, as income rates in
the curb market increase, ex falls, and as interest
rates in the curb markets increase, ex rises. As
the interest rate on deposits rises, deposits rise
and excess reserve holdings fall, since the
interest rate on loans in the official banking
sector is also increased to maintain profitability,
causing ex to fall.
Taking these arguments into account, and
realising that increases in cu and ex reduce the
money multiplier, the money supply function
in log-terms can be constructed as follows:
1n 0 WV = h11nYt + h2 L dt + h3 L ct + 1nHt – qt (8)
where, h1 > 0, i = 1, 2, 3. Thus if we combine
(5) and (8) and realise that the nominal interest
rate is a sum of the real component and the
expected rate of inflation, treated as exogenous,
we have the following equation from the money
market equilibrium:
1nHt = 1n Pdt + 1nqt – a5ne + a61nYt –
a7rct + a8 L dt
(9)
where, ai > 0, i = 6, 7, 8, and a5 = a7, a6 =
–h1 + d1, a7 = h3 + d3, a8 = –h2 + d2.
Note that we are assuming that the money
demand function is more elastic with respect to
real income than the money supply. This
assumption is required to ensure that the
aggregate demand curve is negatively sloped.
Moreover, given that the New Structuralists
assume that an increase in the nominal interest
rate on deposits will result in higher interest
rates in the curb market to clear the money
market, we have to assume that the elasticity of
the money demand function with respect to the
nominal interest rate on deposits is higher than
the elasticity of the money supply function with
respect to the same.
Choosing the appropriate exchange rate
regime is surely a controversial issue. But as
Nag and Mukhopadhyay (1998) and Nag
(2000) point out, with developing countries
depending to a significant extent on imports of
intermediate inputs and lack of growth of
exports due to structural bottlenecks, it is
difficult to maintain a fixed exchange rate
regime. The tremendous pressure on the
balance of payments in an open economic
environment inevitably leads to adoption of
flexible policies of exchange rates. In this paper,
we assume that the monetary authority allows
the exchange rate to float freely. Accordingly,
the equilibrium in the foreign exchange market
is given by equation3 10:
Bt/X0 = a9 (1net – 1nPdt) – 1nYt + 1nYft + a10
(rct – rt*)
(10)
where rt* is the world rate of interest, ai> 0, i =
9 and 10, with a9 > a1 . As in Argy (1994), we
assume that the trade balance is likely to be
more responsive to the real exchange rate than
the aggregate demand. Note that a10 captures
the degree of capital mobility, which can range
from 0 to infinity, indicating no and perfect
capital mobility, respectively. Any positive
intermediate value reflects imperfect capital
mobility. Equation (10) defines the overall
balance of payments given initial exports (X0),
where the first four terms determine the current
account balance. The last term gives us the
capital account balance. Equilibrium in the
foreign exchange market would imply the
balance of payments (BP) = 0.
3
Solution and financial liberalisation
This section discusses first the solution of the
model and then analyses the effects of interest
rate deregulation and lower reserve
requirements on inflation and output.
Equations (4), (9) and (10) constitute the IS,
LM and the BP curves, and, along with (3), can
be solved for Y, rc, Pd and e, realising that Qd =
Qs = Y.
Using (4), (9) and (10) we derive equation
11 for the aggregate demand (AD) curve:
1n 4WG = W1 1nPdt + W2 1nYft + W3 LGW + W4 rt*
+ W5 π WH + W6qt + W71nHt + W8 1nGt
(11)
where
W1 =
W2 =
W3 =
W4 =
W5 =
W6 =
–[a3a9 + a1a10]/Q<0
[a7(a4a9 – a1]/Q?
–a8[a3a9 + a1a10]/Q<0
[a1a7a10]/Q>0
a5[a3a9 + a1a10]/Q>0
–[a3a9 + a1a10]/Q<0
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W 7 = [a3a9 + a1a10]/Q>0
W 8 = a7a2a9/Q>0
Q 8 = [a3a6a9 + a7(a9 – a1) + a1a6a10]/>0
Note that, since a 9 > a 1, the signs of the
coefficient can be shown to be such that the
slope and the shifts of the aggregate demand
curve confirm intuition.
Using (9) and (10) we solve for ln e t and
replacing the resulting solution in (3) we have
the aggregate supply (AS) curve given by
equation 12:
1n 4WV = Y1 1nPdt + Y21nYft + Y3 LGW + Y4rt*
+ Y5 π WH + Y6qt + Y71nHt + Y8 1nGt
(12)
where
Y1 = (1 – b3){[a3a6a9 + b1(a1a10a6 + (a9 –
a1)a7)] + (a3 + a10)[b3b1(1 – b4)] + b2(a3 + a10
– (a9 – a1))}/Q
Y2 = [a6(a1– a4a9)b2 + b3b1(1 – b4) + b2](a6a3
+ a4a6a10 + (1 – a4)}a7)}]/Q
Y3 = a8[(a3 + a10){b3b1(1 – b4)} + b2 (a3 + a10
– (a9 – a1))]/Q
Y 4 = –a 10 [(a 3 a 6 + a 7)[b 3 b 1(1 – b 4) + b 2]
+a1a6b2)]/Q
Y5 = –a5[(a3 + a10)[b3b1(1 – b4)} + b2](a3 +
a10 – (a9 + a1))]/Q
Y6 = [(a3 + a10){b3b1(1 – b4)} + b2](a3 + a10 –
(a9 – a1))]/Q
Y7 = –[(a3 + a10){b3b1(1 – b4)} + b2(a3 + a10 –
(a9 + a1))]/Q
Y8 = a2[(a6a10 – a7){b3b1(1 – b4) + b2) – b2a6
a9]/Q
As suggested in the introduciton, we will focus
on the case of no wage indexation, so we impose
b3 = 0, and sign the coefficients of the aggregate
supply curve. From the above equations, using
the fact that there is no wage indexation, the AS
curve and the coefficients of the same are given
by equation 13:
V
1n 4WQZ
= Y1nw1n Pdt + Y2nw 1nYft + Y3nw LGW + Y4nw rt*
+ Y5nw π WH Y6nwqt + Y7nw1nHt +Y8nw1nGt
(13)
where
Y1nw = {[a3a6a9 + b1(a1a10a6 + (a9 – a1)a7)]
+ b2(a3 + a10 – (a9 – a1))}/Q
Y2nw = b2{[a6 (a1 – a4a9) + {a6a3 + a4a6a10
+ (1 – a4)a7)]/Q?
Y3nw = a8b2 [(a3 + a10 – (a9 – a1))]Q?
SAJEMS NS 9 (2006) No 1
Y4nw
Y5nw
Y6nw
Y7nw
Y8nw
=
=
=
=
=
–a10b2 [(a3 + a1)a6]/Q<0
–a5b2 [(a3 + a10 – (a9 – a1)]/Q?
b2 [(a3 + a10 – (a9 – a1))]/Q?
–b2 [(a3 + a10 – (a9 – a1))]/Q?
a2b2 [a6 (a10 – a9) – a7]/Q?
Given that Q is positive, we impose the following
condition to ensure that the AS curve is
positively sloped, yielding equation 14:
{[a 3a 6a 9 + b 1[a 1a 10a 6 + (a 9 – a 1)a 7)] + b 2
[a3 +a10 – (a9 – a1))}>0
(14)
However, (14) does not allow us to sign the
coefficients corresponding to the two main
variables of interest, the nominal interest rate
on deposits and the reserve requirements. A
sufficient condition for the AS curve to be
positively sloped would be to impose: (a3 + a10
+ a1 – a9)>0, which suggests that the sum of
the interest elasticity of the domestic output and
the trade balance is high enough to outweigh
the difference between the real exchange rate
elasticity of the IS and the BP curves. This
condition is likely to hold for a higher degree of
capital mobility, given bya10, and is obvious
whena 10 tends to infinity. The sufficient
condition also helps us sign Yinw, i = 3, 5, 6 and
7. However, Yinw, i = 2,8 is ambiguous in sign.
Using equations (11), (13) and (14), we derive
the reduced-form solutions and the coefficients
for the output and the price level given in
equations 15 and 16 :
1nYtnw = Ξ 1nw1nYft + Ξ 2nw LGW + Ξ 3nwrt* + Ξ 4nw
π WH + Ξ 5nw qt + Ξ6nw1nHt + Ξ7nw 1nGt (15)
1nPdtnw = L1nw1nYft + L2nw LGW + L3nwrt* + L4nw
(16)
π WH + L5nw qt + L6nw 1nHt +L7nw 1nGt
where
Ξ 1nw = (W2Y1nw – Y2nw W1)/(Y1nw – W1)?(?),
Ξ 2nw = (W3Y1nw – Y3nwW1)/(Y1nw – W1)>0
(<0),
Ξ 3nw = (W4Y1nw – Y4 W1)/(Y1nw – W1)?(?), Ξ 4nw
= (W5Y1nw – Y5nwW1)/(Y1nw – W1)>0(<0),
Ξ 5nw = (W6Y1nw – Y6nw W1)/(Y1nw – W1)>0
(<0), Ξ 6nw = (W7Y1nw – Y7nwW1)/(Y1nw –
W 1)<0(>0),
Ξ 7nw = (W8Y1nw – Y8nw W1)/(Y1nw – W1)?(?)
SAJEMS NS 9 (2006) No 1
and
L1nw = (W2Y2nw)/(Y1nw – W1)?(?), L2nw = (W3 –
Y3nw)/(Y1nw – W1)<0(>0),
L3nw = (W 4Y4nw)/(Y1nw – W1)>0(>0), L 4nw =
(W5 – Y5nw)/(Y1nw – W1)<0(>0),
L5nw = (W6–Y6nw)/(Y1nw – W1)<0(>0), L6nw =
(W7 – Y7nw)/(Y1nw – W1)<0(>0),
L7nw = (W8 – Y8nw)/(Y1nw – W1)?(?)
The first signs of the coefficients corresponding
to the nominal interest rate on deposits, the
inflation expectations, the required reserve ratio
and the required reserve in the solution of the
price level correspond to the case where the
sufficiency condition holds. The sign of the same
set of variables in the brackets corresponds to
the case when the sufficiency condition does
not hold. In the case of the output solution, we
supplement the sufficiency condition with the
Cavallo effect. (See Karapatakis, 1992, Nag and
Mukhopadhyay, 1998 and Nag, 2000, for details
regarding the Cavallo effect.) According to
Cavallo, the supply-side effect of changes in
monetary variables tends to dominate the
demand side effect of the same. So the first set
of signs on the coefficients of the output
correspond to the case when both the sufficiency
condition and the Cavallo effect hold, while,
the signs in the bracket corresponding to the
coefficient of a particular variable refer to the
case when only the Cavallo effect holds, but not
the sufficiency condition.
Moreover, given that Yinw ,i = 2.8 and W2 are
95
uncertain in sign, foreign output and
government expenditure have ambiguous
impacts on domestic output and price level.
Note that an increase in the foreign rate of
interest increases domestic price level, but has
uncertain impact on output. Finally, if the
sufficiency condition holds, an increase in
inflation expectations is inflationary.
Let us now intuitively analyse the effects of
financial liberalisation on domestic inflation
( 3&GWQZ ). In the context of our model, financial
liberalisation implies at least one of the
following: (i) deregulation of the interest rate
ceiling on deposits, that is, an increase in LGW , or;
(ii) lower reserve requirements (qt).
We start off by deriving the reduced form
equation for the rate of inflation by first
differentiating equation (16). A “dot” over the
variable indicates the growth rate, while a D
preceding the variable, indicates a change in the
variable concerned. This differentiating yields
the reduced form equation for that domestic rate
of inflation given by equation (17):
(3&GWQZ) = L1nw ( <&IW ) + L2nwD LGW + L3nwDrt* + L4nw
D π WH + L5nwDqt + L6nw(+& W) + L7nw( *& W )
(17)
If the sufficiency condition holds, we can make
the following observations from this equation:
(i) Interest rate deregulation unambiguously
reduces inflation, and
(ii) A lower reserve requirement policy is
inflationary.
Figure 1
Demand-side effects of interest rate deregulation or tight monetary policy
(when sufficiency condition holds)
96
SAJEMS NS 9 (2006) No 1
Economic arguments from intuition for points
(i) and (ii) can be outlined as follows. An
increase in the controlled rate of interest on
deposits increases the demand for money, and,
hence, the rate of interest in the curb market
has to increase to clear the money market,
causing the LM curve to move to LM1. This
enhances the cost of domestic investment and
shifts the IS curve leftwards, reducing real gross
domestic product and also the import of the
consumption good. In terms of Figure 1, this
implies that starting from an initial equilibrium
at E, the IS curve shifts to IS1. At the same time,
the increase in the UMM rate causes capital
inflow. The resulting surplus will cause the
nominal exchange rate to fall, the IS1 curve to
shift further to the left to IS2 and the BP curve
to move upwards to BP 1, reducing output
further. The new equilibrium in the goods,
money and balance of payments at E* ensures
that the aggregate demand curve shifts to the
left at a given price level. The resulting
movement of the aggregate demand curve is
shown in Figure 2.
On the supply side, the increase in the UMM
rate of interest tends to shift the AS curve
upwards due to the cost-push effect, but the
decline in the nominal exchange rate tends to
reduce the marginal cost of production, by
making per unit import of the intermediate
goods cheaper. The sufficiency condition
ensures that the positive effect on the aggregate
supply curve due to the exchange rate
appreciation tends to outweigh the negative
effect due to the increase in the UMM rate of
interest, causing the aggregate supply curve to
shift rightwards to AS1. The leftward shift of
the AD curve and the rightward shift of the AS
curve ensure a deflation, as can be seen from
Figure 2.
Figure 2
Effect of interest rate deregulation or a tight monetary policy
(when sufficiency conditon holds)
However, unless we assume the Cavallo effect
holds, interest rate deregulation tends to have
an ambiguous effect on the domestic output.
Assuming that the Cavallo effect holds, we move
to a point E1 in Figure 2. From Figure 1, the fall
in the price level causes the real exchange rate
to increase, and shifts the IS2 and BP1 curves
rightwards, with the LM2 curve also shifting
rightwards, due to the increase in the real money
supply, until we reach E1. Note that when there
is perfect capital mobility (a10 tends to infinity),
interest rate deregulation is deflationary,
irrespective of whether the sufficiency
condition holds or not, and expands output if
b2 >a10.
On the other hand, a reduction in the reserve
requirement implies a loose monetary policy,
so the curb market rate of interest has to fall to
ensure the money market equilibrium.
Henceforth, the analysis is exactly opposite to
that discussed above corresponding to an
increase in the controlled interest rate on
SAJEMS NS 9 (2006) No 1
deposits. The aggregate demand curve shifts
rightward while the aggregate supply curve
shifts leftward, causing stagflation, if the Cavallo
effect is in operation.
However, when the sufficiency condition does
not hold, an increase in the nominal interest
rate on deposits, given the Cavallo effect, would
be stagflationary. Since the cost-push effect on
the AS curve, due to a rise in the interest rate of
the curb market, dominates the effect of the
exchange rate appreciation, import of the
intermediate goods will be cheaper.
97
This is the standard New Structuralist critique
of financial liberalisation, in the presence of
UMMs, and is indicated in Figures 3 and 4. So,
once we allow for capital mobility, the New
Structuralist result is not obvious, and is
completely altered if we have high degrees of
the same. Interestingly, when the sufficiency
condition does not hold, a lower reserve
requirement policy will shift the AD and AS
curves rightwards and improve domestic output
and reduce inflation, if the Cavallo effect holds.
Figure 3
Demand-side effects of interest rate deregulation or a tight monetary
policy (when sufficiency condition does not hold)
Figure 4
Effect of interest rate deregulation or a tight monetary policy
(when sufficiency condition does not hold)
98
In summary, the following can be noted:
(i) Deregulation of the interest rate on deposits
and a tight monetary policy (a rise in q or a
fall in H) are unambiguously deflationary
for high degrees of capital mobility;
(ii) The corresponding effect on GDP is
positive, if the Cavallo effect holds; and
(iii)For low degrees of capital mobility, a lower
reserve requirement policy will unambiguously increase output and reduce
inflation, if the Cavallo effect is ensured.
Nominal interest rate deregulation, in this
case, however, will be stagflationary.
If the interest rate is deregulated and reserve
requirements are lowered simultaneously, given
that W2= a8W6, Y2nw = a8Y6nw and a8<1, the
effect of the reserve requirements will always
outweigh the effect of the interest rate
deregulation.
Though it is unlikely that wages will be
completely indexed in a small open developing
economy, analysis of the case below yields
interesting results and policy implications.
Imposing b3 =1 in (10), we have the aggregate
supply (AS) curve given by equation 18:
SAJEMS NS 9 (2006) No 1
Note that, by assuming that the supply curve is
positively sloped, we can sign, Yi, i= 3, 5, 6 and 7.
Using equations (11) and (18), we derive the
solutions for output and the price level as
follows:
1nYtw = Ξ 1w 1nYft + Ξ 2w rt* + Ξ 3w 1nGt(19)
H
1nPdtw = L 1w1nYft + L 2w LGW +L 3w rt* +L 4w π W
+L5wqt + L6w 1nHt + L7w 1nGt (20)
where
Ξ 1w = (W2Y 1w – Y2wW 1)/(Y1w – W1)?, Ξ 2w =
(W4Y1w – Y4wW1)/(Y1w – W1)?, Ξ 3w = (W8Y1w –
Y8wW1)/(Y1w – W1)?
and
L1w =
L3w =
L5w =
L7w =
L1w =
L3w =
In 4WV = Y1nw1n Pdt + Y2nw 1nYft + Y3nw LGW +
Y4nw rt* + Y5nw π WH + Y6nwqt + Y7w1nHt
L5w =
where
Y1w = (a3 + a10)[b1(1 – b4)] +b2(a3+ a10 –
(a9 – a1))}/Q >0
Y2w = [a6 (a1 – a4a9)b2+ [b1(1 – b4) +
b2]{a6a3 + a4a6a10 + (1 – a4)a7)}/Q?
and
Y4w = –a10[(a3a6 + a7)[b1(1 – b4) + b2] +
a1a6b2)]/Q<0
Y5w = –a5[(a3 + a10){b1(1 – b4)} + b2(a3 +
a10 – (a9 – a1))]/Q<0
Y6w = [(a3 + a10){b1(1 – b4)} + b2(a3 +
a10 – (a9 – a1))]/Q>0
Y7w = –[(a3 + a10){b1(1 – b4)} + b2(a3 +
a10 – (a9 – a1))]/Q<0
Y8w = a2[{a6a10 – a7}(b1(1 – b4) + b2) –
b2a6a9]/Q?
L7w =
(W2– Y2w)/(Y1w – W1)?, L2w = (W3–
Y3w)/(Y1w – W1) = – a8 <0,
(W4– Y4w)/(Y1w – W1)>0, L4w = (W5–
Y5w)/(Y1w – W1) = – a5 >0,
(W 6 –Y 6w )/(Y 1w – W 1 )= –1<0,
L6w = (W7– Y7w)/(Y1w – W1) = 1>0,
(W8–Y8w)/(Y1w – W1)?
(W 2 – Y 2w )/(Y 1w – W 1 )?, L 2w =
(W3– Y3w)/(Y1w – W1) – a8 <0
(W 4 – Y 4w )/(Y 1w – W 1)>0, L 4w =
(W5– Y5w)/(Y1w – W1) = a5 >0,
(W6– Y6w)/(Y1w – W1)=–1<0, L6w =
(W7– Y7w)/(Y1w – W1) = 1 >0,
(W8– Y8w)/(Y1w – W1)?
Perfect wage indexation ensures that the
solution of the output is independent of the
monetary policy parameter and inflation
expectations. However, just as in the case with
no wage indexation, the effect on output
corresponding to a fiscal policy change is
ambiguous, since the effect on the aggregate
supply curve is uncertain.
Differentiating (20) once yields the reduced
form equation for the domestic rate of inflation,
given by equation (21).
( 3&GWZ) = L1w ( <& IW ) + L2wD LGW+L3wDrt*+L4wD π WH
+ L5wDqt +L6w( +& W) +L7w(*& W )
(21)
SAJEMS NS 9 (2006) No 1
99
Figure 5
Demand-side effects of interest rate deregulation or a tight monetary
policy (with perfect wage indexation)
Figure 6
Effect of the interest rate deregulation or a tight monetary policy
(with perfect wage indexation)
So, from the above equation and figures 5 and 6
we can make the following observations:
rates and real interest rate remaining unchanged
as well.
(i) Deregulation of the interest rate on deposits
and a tight monetary policy (a rise in q or a
fall in H) are unambiguously and unconditionally deflationary; and
4
Conclusion and suggestions for
further research
(ii) The corresponding effect on the GDP is,
however, neutral.
Note that in this case the fall in the price level
corresponding to deregulation of the nominal
interest rate on deposits or tighter monetary
policy causes the IS, BP and the LM curves to
return to their original position, ensuring the
effect on output is neutral, with real exchange
This paper modifies the standard MundellFleming model and analyses the effects of
financial liberalisation on domestic inflation
and GDP. Considering a small open financially
repressed economy characterised by a UMM,
no wage indexation, intermediate goods
imports, and capital mobility, we have seen that
100
interest rate deregulation is inflation reducing
for economies with higher degree of capital
mobility. The effect on output is, however,
uncertain, and will only increase if the Cavallo
effect is in operation. For economies with lower
degrees of capital mobility, financial
liberalisation in the form of lower reserve
requirements will enhance output and, if the
Cavallo effect holds, lower inflation. The
stagflationary outcome of interest rate
deregulation, as claimed by the New
Structuralists, is not an obvious outcome in
economies characterised by curb markets. This
discussion shows that stagflation is possibly a
result of limited capital mobility in a flexible
exchange rate regime, and not the mere presence
of a competitive and agile curb market.
To put the analysis differently, the policy
prescriptions of this paper can be summarised
as follows: The analysis shows that if reducing
inflation is a priority, the government may
ensure high capital mobility, and deregulate the
domestic rate of interest. On the other hand, if
the government values increase in output and
employment generation relatively more in their
loss function, financial liberalisation should be
in the form of lower reserve requirements with
capital controls. Moreover, in an economy
characterised by perfect wage indexation, the
government can always ensure lower levels of
inflation by deregulating the interest rate and
pursuing a tight monetary policy. However, the
only prerequisite for such a policy choice is the
establishment of a flexible exchange rate
regime; degree of capital mobility is irrelevant.
An extension of the current analysis would be
to make endogenous the process of expectation
formulation along the lines of rational
expectations, and analyse whether such a change
affects our existing results. Further, since the
current model is without any microfoundations,
it would be interesting to analyse the long-term
effects of financial liberalisation on growth and
inflation in a dynamic general equilibrium
model.
SAJEMS NS 9 (2006) No 1
Endnotes
1
2
3
This paper was written as a part of my coursework
in Monetary Theory and Policy at the University
of Connecticut. I am particularly grateful to
Professor Stephen M. Miller, Professor Steven F.
Koch, and the two anonymous referees for many
helpful comments.
The firms receive fixed loan amounts from the
banking sector at an administered rate. The
shares of bank loans for fixed capital formation
and the intermediate input are assumed to be
exogenous, as Karapatakis (1992) suggests. With
no differences in the lending rate between the
two types of credit, it can be assumed that these
shares depend exclusively on the discretion of the
commercial banks. The remaining part of the
firms’ demand for loans (for the two purposes) is
financed by the curb market at the market
clearing rate.
Since the curb market rate of interest is the true
opportunity cost of the asset market, its
movement relative to the world rate of interest
determines the direction of capital flows (see Nag
(2000)). Moreover, the expected rate of exchange
rate depreciation has been assumed to be zero,
just as a simplification, simply because in our
model expectations are exogenous (see Argy
(1994) for details).
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